High interest rates have been a boon for Americans who hold onto cash, but many on Wall Street are warning investors to start thinking ahead. Since the Federal Reserve started raising interest rates, people have flocked to cash vehicles like money market funds and certificates of deposit. Total assets in money market funds hit a record high of $6.12 trillion in the week that ended Wednesday, according to the Investment Company Association. Interest rates are likely to remain higher for longer, with the Federal Reserve predicting only one rate cut this year. Investors may be tempted to hold onto short-term instruments in search of higher yields (the Crane 100 Money Fund Index has a seven-day annualized yield of 5.12%), but holding onto them comes with reinvestment risk. “With the Fed’s rate cuts on the horizon, if short-term rates fall in the coming days, you won’t be able to get a 5%+ yield when it’s time to reinvest your money,” Cathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research, said in her midyear bond outlook last week. Instead, investors who want to lock in a 5% or higher yield for a long time can choose investment-grade corporate bonds or agency mortgage-backed securities (MBS), he added. According to the Bloomberg U.S. MBS Index as of June 3, agency MBS have a duration of about six years, Jones noted. Duration is a measure of how sensitive a bond’s price is to interest rate fluctuations. Bonds with longer durations tend to have longer maturities. Moreover, agency MBS have coupon yields of about 5.7%, “attractive levels for a high-quality, highly liquid sector,” says Leslie Falconio, chief investment officer at UBS Americas. Agency MBS, which turn to mortgages for yield, are part of the overall residential mortgage-backed securities (RMBS) sector. RMBS are debt created from pools of mortgages whose cash flows are tied to the interest and payments on those loans. Agency MBS are guaranteed by the government and issued by government agencies such as Fannie Mae, Freddie Mac and Ginnie Mae. Wells Fargo also believes it’s time to start moving money out of cash and into longer-term assets by dollar-cost averaging, or adding exposure over time, said Luis Alvarado, global fixed-income strategist at Wells Fargo Investment Institute. Right now, the mortgage-backed securities sector looks attractive because of its relative value compared to investment-grade corporate bonds, he said. The firm recently raised its ratings on the securitized sector, which includes RMBS, to favorable from neutral and downgraded its ratings on Treasuries to neutral from favorable. Investors can get exposure to MBS through exchange-traded funds. Alvarado likes the higher quality of RMBS, which includes agency and non-agency mortgages. While supply is expected to remain flat, he expects demand from banks to grow as bank loan growth slows. “We believe that residential mortgage-backed securities (RMBS) will be a big recipient of inflows because they offer strong credit quality, ample liquidity and a relative advantage over IG corporates, especially in spread differentials,” he said. UBS also currently likes agency mortgage-backed securities. Interest rate volatility over the past year has weighed on the sector, causing it to lag behind corporates, Falconio said. That’s why they’re undervalued relative to BBB corporates, he noted. The UBS Americas chief investment officer expects a soft landing and two Fed rate cuts this year, but Falconio said it doesn’t necessarily matter if it’s one or two. “What we’re looking for is 1) a cut this year and 2) a near zero chance of rate hikes, which is what’s happening,” he said. He noted that agency MBS are also AAA-rated. “We think this asset class is going to perform very well going forward,” Falconio said. “Corporate MBS are also AAA-rated. [spreads] It’s tight… it’s a high quality asset class where you earn 5.7[%] “Yields are high and spreads are roughly one standard deviation cheaper than current coupons,” she added. “And we’re at the point in the cycle where the Fed is starting to cut rates, which will also help the sector.”
Mortgage-backed securities are popular on Wall Street because of their attractive yields and relative value.
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